Commercial and Industrial (C&I) lending has reached a new high with $2.35T in outstanding C&I loans to businesses as of Q2 2019. [1] In the past 5 years, outstanding C&I loan volumes have grown by a CAGR of 7%. The top 100 banks (by asset size) have followed a similar trend and have grown by 7.5% over the same period. This comes as no surprise amidst near-record low default and interest rates (Fig. 1).  

Within the banking industry, 60% of outstanding C&I loans are held by banks with more than $10B in assets, a trend which has remained consistent over the past 5 years. While the share of outstanding loans held by the top 4 banks – Wells Fargo, Bank of America, JPMC and Citi – hasn’t changed much, their growth rates have started showing a decline (Fig. 2).  

Fig. 2 – Top 4 Banks’ Share of Total C&I vs. YOY Change in C&I Outstanding
(Source: Federal Reserve Statistical Release) 

This might seem like a puzzling trend –  why would the growth rate of the top banks in a healthy market show a decline? We may be observing the convergence of a few seemingly disparate trends, which could be explained in part using fish.

Yes, fish.

  _________

Contemplate the natural order within a lake inhabited mainly by large fish. They patrol the entire lake for available food, and if a smaller fish appears in their territory it quickly becomes a part of their diet.

Now let’s say after a while the big fish discover a new, plentiful food source localized in the warm shallows of the lake. They may start spending most of their time in this area and neglect the deeper areas where food is still available but has become harder to procure. This allows smaller fish to appear and eventually thrive in the deeper areas, making it difficult for the large fish to return should the need ever arise.

Now let’s use this lens to re-examine our lending scenario.  

• It could be that big banks – our “big fish,” so to speak – are retreating from marginally profitable lending spaces but maintaining their market share by lending larger amounts to a smaller pool of clients. Their revenue is still growing, albeit at a lower rate, but they’re beginning to retreat from loans to smaller businesses. 
• The data show this beginning in 2016, when average C&I loan sizes by the Top 4 Banks troughed at $84K (Fig. 3).  Since then, the average loan size has grown by 13% to $95K per loan. This has coincided with a reduction in the growth rate of C&I outstandings by the Top 4 banks, from a 8% CAGR in 2010-2016 to a 6% CAGR in 2016-2018. 

Fig. 3 – Top 4 Banks’ Total C&I Outstanding vs. Average Loan Size – 2010-2018
(Source: FDIC & FFEIC)

So who are the ones taking out loans, the “food source” for all the fish in the lake? While most large corporations can meet their financing needs from banks due to their strong credit history, audited financials, and ability to meet regulatory requirements, small and medium-sized businesses have historically presented an under-served segment of the lending industry.

John Birge, Chief Risk Officer at Credibly, remarked on another nuance of large banks’ involvement in the small business lending space. “The fixed costs of underwriting a small business loan for $100k is roughly the same as a $1M loan, but obviously profit is far less. Hence banks have never really wanted to play heavily in SME lending.” 

It’s no secret that securing financing is a challenge for small businesses. Recent data from the Small Business Credit Survey (SBCS), an annual national survey run by the New York Fed on the financing needs of small businesses, provides deeper insight into this reality.

The survey finds that overall 69% of small businesses must still rely on their personal savings to meet financing needs. Among all small businesses—applicants and non-applicants— the SBCS finds that less than half (48%) indicated their funding needs are satisfied, 23% have shortfalls, and another 29% – including debt-averse and discouraged firms – may have unmet funding needs. When seeking loans, 86% of employer firms rely on their owners’ personal credit scores, a percentage that has been remarkably stable over time.

Given a choice between taking out loans from banks or online lenders, the decision criteria for small businesses show some similarities, but also some telling differences. If considering a bank, survey respondents cited (in order of decreasing importance)

• Having an existing relationship with large bank (58%),
• Chance of being funded (37%)
• Cost or Interest Rate (29%)

When considering online lenders, their top priorities became:

• Speed of decision/funding (63%)
• Chance of being funded (61%)
• No collateral required (45%)

In either instance, small businesses mentioned ‘long wait for credit decision or funding’ as their top challenge, followed by ‘difficult application process’ with large banks and ‘high interest rate’ with online lenders. Approval percentages for medium and high credit risk applicants were higher with online lenders than at banks, with actual approval rates of 76% to 34% respectively. [2]

All this reinforces the importance of watching a key development – the increasing market presence of alternative lenders.

WHY DO WE NEED TO PAY ATTENTION TO ALTERNATIVE LENDERS?

Alternative lenders are sometimes referred to as “subprime” or “near-prime” lenders, as opposed to “prime” lenders, in reference to the credit-risk characteristics of those applying for loans. What may not have been much of a threat to banks in years past is increasingly a source of growing competition for them. Selected payment companies (eg: PayPal, Square) and online balance sheet lenders (eg: OnDeck, Kabbage, Credibly) are some of those “mid-size fish” starting to move into territory once occupied by “big fish” banks.

Loan originations at 6 of the most prominent alternative lenders (OnDeck, Kabbage, Square Capital, Kapitus, RapidFinance, Credibly, Shopify) were $9B in year 2018, with a corresponding growth rate of 63% from 2017. In fact, in the past 4 years these 6 lenders have quadrupled their origination volumes. Though they remain a scant 1% of total C&I loans outstanding, this share has grown rapidly in the past 4 years as more small and medium enterprises turn to alternative lenders for financing (Fig 4).  Applications to online lenders continue to trend upward: of those surveyed, 32% of applicants in need of external funding turned to online lenders in 2018, up from 24% in 2017, and 19% in 2016.

Fig. 4 – C&I Loans Outstanding vs. Alternative Lender Share Over Time
(Source: FRED)

In other words, alternative lenders are not yet at a point where they are completely overtaking banks as a source of funding for small and medium-sized enterprises (SMEs), but if they remain on their current growth trajectory, that could change.

Banks, for their part, are not oblivious to these developments, and there have been notable instances of large banks seeking partnerships with online lenders. In 2016, JPMorgan Chase and OnDeck collaborated on Chase Business Quick Capital, their digital banking small business lending product. Though originally slated for a four-year partnership, JP Morgan Chase withdrew early in July 2019, saying that it will continue to offer online small-business loans, but will no longer do so in partnership with OnDeck. OnDeck took a $900,000 impairment charge in the second quarter for technology that supported JPMorgan loan originations. The company said that it will continue to service previously originated JPMorgan loans for up to two years. [3]

Key differences to note between Banks and Alternative Lending

1. Typical loan term for alternative lenders ranges from 6 to 18 months, though sometimes running up to 3 years. Loan terms for banks usually fall in the 3-to-5 year range, but could go as high as 10 years.
2. Loans from traditional lenders, such as banks or credit unions, can have annual percentage rates (APRs) ranging from 4% to 13%, while alternative or online loans can have APRs ranging from 7% to over 100%.
3. Some industries – particularly those typically considered high-risk from a lender’s perspective like trucking/transportation and construction– may have a very slim chance of securing a loan from banks but could easily get loans from subprime lenders. [4]
4. The biggest players emerging in the alternative lending space offer online and mobile applications, many of which can be completed in under 30 minutes. Rather than online inquiries, these are complete loan applications offered entirely online. By contrast, the process for securing some form of credit at conventional banks may require small businesses to spend approximately 25 hours on average filling out paperwork as part of the application process.
5. While a traditional bank would ask for credit score above 680; a business’s profitability; 2+ years age of business; and annual revenue of $250k+ in order to consider an applicant for a loan, alternative lenders usually look for a 500+ credit score; do not usually require a profitability report; 1+ year age of business; and an annual revenue of $100k. [5]

    

THE APPEAL OF ALTERNATIVE LENDERS TO SMALL BUSINESS

Biz2Credit’s August 2019 index — which measures activity among accounts receivable financiers, merchant cash advance lenders, CDFIs, micro‐lenders, and others — notes that small business loan approval rates by alternative lenders runs above 60%, versus 28% for large banks. (Fig. 5) (Approval rates often vary dramatically among these platform types.) [6]

Fig. 5 – Small Business Loan Approval Rates
(Source: Biz2Credit Small Business Lending Index, August 2019)

From a regulatory perspective, banks may be at a strategic disadvantage when it comes to small business lending. Reform acts and regulatory frameworks such as the Dodd-Frank Wall Street Reform and Basel III international regulatory framework for banks put large lending and financial institutions under strict scrutiny. These regulations laid down stringent rules for mandatory capital reserves for banks and new underwriting requirements, which limited the amounts and kinds of loans major banks could process and approve.

By contrast, the alternative lending industry is not subject to the same regulatory standards as traditional banks. The formation of the Innovative Lending Platform Association (ILPA) is a stride for self-regulation of the alternative banking industry. The ILPA is a trade organization formed by and for online lenders, dedicated to advancing standards and best practices to help support responsible innovation for fintech lenders and providing easy, stress-free access to capital for small business owners. [7]

In addition to the rise of alternative lenders, other trends that could impact the small business lending space over the coming years include:

• Lender transparency: California, along with New York and New Jersey, is working on the Truth in Lending Act, which will require all small business lenders to tell applicants what annualized rate they’ll charge for financing. This could provide additional transparency but reduce the appeal of relatively short-duration, high-interest-rate loans. 
• Artificial Intelligence: The growth of online lenders goes hand-in-hand with artificial intelligence making its way into the small business lending space. Among other use cases, AI is being used to provide faster approval times, detect fraud, and reduce operating expenses. The maturing technology may not guarantee an advantage, however. Birge observed that companies with an over-reliance on emerging technologies may face challenges should the credit environment weaken. “ML / AI are great tools but do not replace the craft of lending,” said Birge. “Successful alternative lenders merge both AI/ML and time-tested lending best practices like robust portfolio management and collections.”   

WHAT DOES IT ALL MEAN?

While the commercial lending space continues to be attractive for lenders of all sizes and breeds, larger banks’ recent focus on offering larger loans to larger companies creates an opportunity for alternative lenders to continue building a significant presence in the SME lending space.

Returning to our lake metaphor, the longer the large fish continue to focus on patrolling the shallows, the higher the chance of a competing species developing in the deep end.

By the time the large fish decide to return, they may find the deep end a far less hospitable place.

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